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Thursday, 3 January 2013

Slaying the inflation monster

In recent articles in the Telegraph and the FT, Andrew Sentance called for the (permanent) end of quantitative easing and a return to higher interest rates in 2013 to counteract inflationary pressures in the UK economy. His reason for this is that that UK inflation has been higher than the Government's 2% target for most of the last five years, despite the Bank of England continually forecasting its imminent fall, and there are developing domestic and global pressures which will push up inflation over the next few months. The Bank of England recognises these in its short-term inflation forecasts but is still forecasting lower inflation over the medium term. However, it is fair to say that the Bank of England's record on inflation forecasting is somewhat tarnished, and Sentance is a reputable economist and a former member of the MPC. So his argument in favour of tighter monetary policy deserves careful consideration.

The first thing to consider is Sentance's analysis of the causes of the present above-target inflation. He notes correctly that world commodity prices, especially foodstuffs, have risen and are likely to continue to rise in 2013. Part of the rise in commodity prices can be attributed to the QE programmes undertaken by the US, UK and Japanese central banks since 2009: part also can be attributed to investors seeking safe havens for their money: and part to other factors, such as increasing demand from emerging markets, the Iran stand-off affecting oil prices, and drought in the US and Central Europe affecting food prices. None of these except QE can be attributed to the domestic economic environment in the UK. They are all, without exception, external pressures.

For some reason Sentance completely ignores the main cause of the recent spike in CPI inflation, which is the introduction of higher student tuition fees. Their effect will be felt in higher CPI figures for a year, just as the Government's VAT rise increased reported CPI for a year. But why tuition fees are included in CPI at all is a mystery to me, since they are by any reasonable definition investment rather than consumption, and they only affect a relatively small, largely homogenous group of people. To get a fair view of real inflationary pressures in the economy, surely the effects of government tax rises (tuition fees are effectively a tax) should be eliminated - not ignored.

What Sentence DOES include is the devaluation of sterling in 2008, which he believes will continue to cause inflationary pressure in the economy for years to come. And he says that "creeping tolerance of higher inflation" in the 1960s led to the double-digit inflation of the 1970s. This is simply wrong. He ignores the 1967 devaluation of the pound, which set off an inflationary spiral which was then exacerbated by the oil price shock of 1973 and the secondary banking crisis of 1973-5.

Now, the 1967 experience shows that devaluation can indeed cause inflationary pressures. But the 2009 devaluation was larger than the 1967 one and yet has not had anything like the same effect. A quick look at the inflation record from sterling's 1967 devaluation to the intervention of the IMF in 1976 shows a very different picture from the 2008 base rate cut that devalued sterling by about 25%*. Inflation started to rise dramatically immediately after the 1967 devaluation, reaching 9.4% in 1971- from a low of 2.5% in 1967 before devaluation. Compare this with the 2008 base rate cut: inflation actually fell after that cut and was below zero in 2009, then rose to a high of 5.2% before falling again to its present level of 2.7%. And part of the increase to 5.2% was explained by tax rises. Really, in what way are these scenarios remotely similar? Unless there is an oil price shock or another banking crisis, what reason is there to think that inflation is about to take off and reach the dizzy heights of the mid-1970s? Come to that, what reason is there to think that sterling is about to collapse in the way that it did in 1976, when the Chancellor was forced to ask for help from the IMF to choke off a run on sterling? I can only think that Sentance hasn't bothered to do his homework on the causes of the 1970s inflation. More importantly, he seems to ignore the considerable changes in economic management since the 1970s.

In the 1970s, government was responsible for both monetary and fiscal policy. But it didn't really use monetary policy much as a tool - the preferred means of economic management was fiscal policy, with the primary aim being full employment. There was a prevalent belief that inflation could only happen in a growing economy, so economists and politicians were baffled by the combination of high inflation and a stagnant economy - "stagflation", as they termed it. But there was no attempt to manage inflation directly using monetary methods, as central banks do now - and to be fair to central banks, the evidence of the last twenty years is that they have generally been pretty successful in controlling CPI inflation, though maybe at the price of distortions elsewhere (whether inflation alone is a sufficient target for economic policy is a matter of considerable debate at the present.) No, in the 1970s they tried to control inflation by means of fiscal tools, notably the notorious prices & incomes policies that were universally hated and undermined by union power in the large state-controlled industries of the time. Yet Sentance seems to think that central bank inflation targeting is being completely abandoned in favour of failed 1970s-style fiscal policies and inflation will skyrocket. Really this is a terrible indictment of his former colleagues on the MPC. I hope they didn't send him Christmas cards.

So is inflation likely to rise in 2013, as Sentance thinks? Yes, it will rise a bit, due to government policy (including permitting above-inflation price rises by privatised utilities) and external pressures. But there is no evidence that there is significant domestically-generated inflationary pressure over the medium-term - which is all that interest rates can realistically influence. So in my view there is no justification for interest rate rises in the foreseeable future. Raising interest rates to calm down a one-percent increase in inflation which is almost entirely due to government policy would be idiotic. And raising interest rates to choke off an increase in inflation due to price rises in essentials such as energy and food would be utterly ineffective. All it would do is hurt people and businesses who are currently just clinging on to solvency, resulting in mortgage defaults, business bankruptcies, job losses and personal bankruptcies. Yes, higher interest rates would help better-off pensioners whose income is partly made up of interest on savings, and it would give savers a better return on their investments. But why should hard-pressed working people on low incomes lose their jobs and their homes to ease the pressure on better-off pensioners and pad out the savings of the well-off? I am utterly unimpressed by Sentance's attempt to cast himself as St. George, rescuing the UK economy from the clutches of the inflation monster. It's a fairy tale.

But Sentance is far from being the only person who thinks that inflation is about to take off. Here's Bill Gross of PIMCO (h/t Izabella Kaminska):

While they are not likely to breathe fire in 2013, the inflationary dragons lurk in the “out” years towards which long-term bond yields are measured. You should avoid them and confine your maturities and bond durations to short/intermediate targets supported by Fed policies.

Well, I suppose we should be thankful. Unlike Sentance he doesn't seem to think the inflation monster will surface in 2013, so isn't suggesting we should deploy anti-inflation guns now (i.e. raise interest rates). But he's definitely a believer. As are most investment advisers. Here's the American edition of Money Morning predicting inflation in 2013 due to the fiscal cliff and monetary expansion:

The bottom line is that there's a substantial chance of a sudden upsurge in inflation in 2013, though the government statistics may reflect it only very grudgingly.

And here's a whole clutch of believers reported in the Economist in September 2011. No, that is not a mistake - 2011. They expected inflation to be well above what it is now:

Meanwhile in Britain, inflation expectations have risen to a three-year high, with those polled expecting 4.2% over the next year and 3.5% over the next five. Those figures are well above the Bank of England's target.

Though this monster is only small. Some people believe in a much larger one - a hyperinflation mega-monster. But whatever the size of your monster, the question is whether it really exists, or whether like St George's dragon it is is a creature of fantasy.Well, both ordinary inflation and hyperinflation are surprisingly common. The Cato Institute documents 56 known cases of hyperinflation, all except one (the aftermath of the French Revolution) in the last 100 years. Ordinary inflation has been moderated in Western countries in the last decade or so, but emerging markets have much higher levels of inflation and history shows that Western economies have at times also experienced much higher levels. So it is reasonable to expect inflationary pressures at some point, though I think it will be quite some time before they are significant enough to warrant monetary tightening . But hyperinflation? Cullen Roche identifies five characteristics of hyperinflations, and he admits that the US might show signs of some of them. But it's not the best candidate by a country mile, and neither is the UK.It is no surprise that investors and their representatives are those most afraid of the inflation monster in its various forms. For when inflation takes hold, savings lose value - in fact in hyperinflation, savings are worthless unless held in the form of physical assets such as gold. And the defining feature of our age is risk aversion. Investors are desperate to protect their wealth, fearing losses by direct confiscation (taxation, debtor default) or by stealth (inflation, negative interest rates). And people make money from investors' fears. Those who predict hyperinflation and encourage people to move their savings into gold - guess what they are long in? Those who predict ordinary inflation and want interest rates raised so bond yields can get off the floor - guess what they are holding? And some play on fears for overt marketing purposes. The supposedly reputable magazine Money Week recently produced an article predicting total financial collapse in the UK - but not to inform their subscribers. No, it was to sell new subscriptions to their magazine. And it contained some of the worst abuse of statistics and misuse of financial economics that I have ever seen. What a disgrace.Slaying the inflation monster is important. But so is slaying the unemployment and under-employment monsters, which are wrecking the lives of millions of people, especially the young. And so is slaying the debt deflation monster, which is crippling millions of households and businesses. It is these that roam the Western world at the moment, while the inflation monster is nowhere to be seen. No doubt it will return, but its time is not yet. We should fight the real monsters, not the imaginary ones.

* The two devaluations were very different. In 1967 the pound was still linked to gold on the Bretton Woods standard, so the government directly changed its value in relation to gold. We now have floating exchange rates, so the central bank influences sterling's value by means of interest rate policy and intervention in currency markets.

The hyperinflationists are stuck in a weird mish mash of wrong ideas involving Quantity Theory of Money which was debunked in the 30s whereby a currency is "debased" by printing. Hyperinflation is a function of a plunging exchange rate and nearly always involves debts in foreign currency.

His claim that the depreciation of Sterling is an ongoing cause of inflationary pressures in the UK is nonsense. The depreciation of Sterling in 2007 was a one event, since then Sterling has actually appreciated (e.g. it's up 5% and 4% against the Euro and USD respectively in the last 2 years).

He appears completely ignorant of the optimal inflation targeting literature (Aoki 2001 and Mankiw and Reis 2003). Which concluded that central banks can maximize the stability of economic activity by targeting core inflation, and sticky or persistent prices. This implies central banks should pay more attention to nominal wages and less to headline commodity prices.

In the UK core inflation and constant taxes inflation has been very modest over the last four years, and nominal wages rises are extremely depressed. Thus it seems counter-intuitive to worry about inflation when unemployment rate has barely fallen in two years and growth in GDP (real or nominal) has been so low.

You have to wonder what indicators would lead Sentance to call for further easing of monetary policy? Would 20% unemployment and a further 10% fall in NGDP be sufficient?

I think I showed that Sentance's views on inflation and the 2009 depreciation were totally wrong.

Very interesting points about nominal wages. I would add to that that the CPI calculation ignores all forms of couponing, distress selling, BOGOF deals and their variants, loyalty cards and all the other ways that retailers use to cut real prices without cutting nominal ones. It is very evident that retailers are discounting heavily in all sectors except privatised utilities (which have a captive market and no competition, as Sentance notes). That is consistent with depressed nominal wages, too. The construction of the CPI therefore prevents it from reflecting the real deflationary trend.

Sentance has been persistently hawkish throughout the crisis and subsequent slump. He disagreed with the 2009 base rate cut and has been trying to restore it ever since. Hell would freeze over before Sentance called for further monetary easing, I reckon.

Apart from the 1967 devaluation, I think there was another factor behind the 1970s inflation. Ridiculous wage claims. Wages took 65% of GDP in the mid 70s, which is an unprecedented figure. The average figure for the 50s and 60s was about 59% and the average over the last 20 years even less: about 55%. I got the figures from a chart at economicshelp.org, but I’ve lost the address.

I.e. labour refused to accept that a country with a serious balance of payments deficit has to cut its standard of living to below what it would otherwise have been. But worse than that, labour decided to put the boot in some more.

"Those who predict ordinary inflation and want interest rates raised so bond yields can get off the floor - guess what they are holding?"

Clearly, not bonds by this logic? Unless you are mom'n'pop and intend to hold them to maturity. But how many sophisticated investors intend doing that these days?

"The printing is a result of hyperinflation. Not a cause."

Quite. A shortage of money - because each unit has become worth less than it used to be, in real terms. Hyperinflation is not "high inflation".

When one looks at, say, Zimbabwe during the hyperinflation there and consider the local prices but denominated in some other currency that is not hyperinflating... it turns out to be a deflationary depression. If prices were really rising in real terms ("inflation") then we would expect to see goods flood into that economy from outside, to satisfy demand and the inflationary forces would be quickly overwhelmed.

Hyperinflation is a currency event. A catastrophic loss of confidence in the currency.

What we experience today is a global deflationary depression as 20+ years of leverage is unwound. It is being fought tooth and nail with QE ("making sure it doesn't happen here"). The Fed/BoE are right to be concerned about allowing the obvious, currency debasement, to become widely understood to be a permanent feature of the monetary system going forward. But truly, expansion of the monetary base is at this point unavoidable.

IMO, in a bid to avoid hyperinflation, we should expect a deflation scare in 2013, followed by swift resumption of QE programmes. So let's see how the year progresses.

Great post. Particularly good to hear someone pointing out that national interest rates are a very blunt tool to be looking at when you're talking about inflation due to global commodity prices.

The nominal wages point is a good one, because most of the past episodes of inflation in 1st World economies have been about wage inflation - but so far it's different this time. Indeed, it's notable that few economists are able to make clear statements about the definition of inflation - too many (including Sentance it seems) work all policy prescriptions off national wage inflation, even when the real problem is asset inflation (last crisis) or global demand for constrained resources (this time around so far.)

We have been living in an era of deflation since the 2008 financial crisis with inflation vigilantes worsening the situation from central banks to inflationary hawks by not allowing for the cleansing effects of slightly higher inflation/expectations and a redistribution of income from creditors to debtors. The result, historically low long term yields unable to boost economic growth and employment, economies mired in slow growth and a debt overhang which may take decades to write down to manageable levels if policies remain unaltered. The QE embraced by most central banks of indebted countries has helped but should be reinforced without half measures and the threatening fear of higher inflation for it is no more than fear for as long as long term bond yields do not predict otherwise and to my knowledge till very recently, they have been showing the exact opposite.

In fact Central Banks should aspire to create market induced sustainably higher long term yields for it is this indicator which should lead us to expect stronger growth.

Frances, excellent article. Your ability to articulate economics is one of the best I have seen. This is possibly because you are also a musician with many other strings to your bow no doubt. You are right to close your piece with a warning about unemployment. Unless this real monster is tackled, there is great risk of future social disorder that will threaten everything. The relative stability and adherence to law in the UK and other western nations is a key factor in retaining value in assets (property, land, manufacturing) and attracting super-rich to London, Paris etc. We had better hope that politicians will soon turn their attention to social justice for the young and pay less attention to playing with the economy, which history shows us is something they haven't a clue about.

The entire way inflation is measured and the items included have no bearing whatever on the average person and particularily pensioners Food and utility costs have escalated out of all proportion and the miserly CPI. Increases in state pension do not begin to touch the increasesHence all those on fixed incomes or pensions are getting poorer by the day Add on those who rely on savings income and the situation is dire

You have a government that increase rail fares and repayment of student loans by RPIYet CPI is used for everything elseIts all lies ,deceit and smoke and mirrors

About Me

In a past life I worked for banks...now I write about them. Actually I write about finance and economics generally. And about anything else that interests me - so you may occasionally find posts on this site that have nothing to do with banking, economics or finance. In fact they might have something to do with music, since I'm a Associate of the Royal College of Music and a professional singer and teacher. I'm also an alumnus of Cass Business School, where I did an MBA with a specialism in finance and risk management.
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